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Costco (COST) - Using Economies Of Scale And Subscriptions To Master The Wholesale Experience

by Alex Mason | Companies, Episodes

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Mental Details

Description

  • Although Costco didn’t invest the wholesale concept, one might think that they have perfected it. One of only a few companies able to compete with Walmart’s Sam’s Club, Costco focuses on providing quality products to people at very low prices, and they do it by selling in bulk with a “no frills” approach.
  • In today's episode we cover the history, business model, financials, and future outlook of Costco.

Transcripts:

  • Alex Mason: Today on the show. We're talking about one of the world's largest retailers and no, it's not Walmart. In fact, this is a company that has mastered the wholesale concepts. Today. We're going to talk about Costco. I'm Alex Mason, host of stock stories. This is the podcast where we decode investing principles by analyzing the business behind the stock, as well as learning about mental models in order to help you become a better investor.
  • [00:00:32] You ready? Let's go.
  • [00:00:34] All right, All right, all right, all right. Welcome. Welcome to the show. This is the stock stories podcast and my name is Alex Mason, and yes, I am your host and stock storyteller. Thank you for coming back to the show. Thank you for joining me again. It's a new year 2021. We're ready to kick it off. Right. I hope you enjoyed last week's episode.
  • [00:01:25] That was kind of a different episode. I really just wanted to go through and, you know, sometimes you just need to process things, right? Like 2020, there were so many things that happened and I hope it helped you as much as it helped me just to kind of go through and understand a little bit more about what happened in the markets, how the coronavirus affected everything, the resulting.
  • [00:01:48] Recovery in the markets interest rate situation and looking forward into this year and beyond. So I really hope that was helpful, helpful for you. And I'm so excited because this year I'm going in, I'm just going in with this show. There's so many things I have planned and I am working frantically behind the scenes to try to bring.
  • [00:02:12] All of the ideas and things that I want to share with you, to you. So that'll be coming in the future and I'll definitely keep you posted about that. But as far as today, today, we're going to talk about another company. Like I said, at the very beginning, it's one of the world's largest retailers using the wholesale model.
  • [00:02:33] Costco. And Costco is really different than a lot of businesses. It's a retail business, but it is certainly a powerhouse in its own, right. Compared to many other retailers. So without further ado, let's just go ahead and get right into it. Let's talk about Costco.
  • [00:03:03] Alright, today, we're going to be talking about Costco, ticker symbol, C O S t now, before we get started, I do want to also mention if you have been listening to the show for a while, if you're enjoying these episodes we're going through the entire & P 500 and mental models as well, if you find this so valuable, It would really help me out if you just shared the show with one person this week, share it with one person who you believe would really also benefit from this content.
  • [00:03:34] Thank you so much in advance for that. So the way that these episodes are structured, if you are new to the show, is. We like to look at companies really holistically. I don't give, buy or sell recommendations on this show. I don't tell you everything. That's wrong about a company. I don't tell you everything.
  • [00:03:52] That's right about a company. What I want to do is provide you a really good overview, a starting point for your research of how to think about businesses and how to think about their corresponding stocks in the market. So that you can make an intelligent decision and. They're constructed in kind of a timeline.
  • [00:04:14] These episodes are constructed with a specific timeline in mind. First, we talk about the history of the company itself. What is the context? Why are we, why do we even care that this company exists? It had to come into existence for a reason. Right? And so understanding that background, I find really helpful.
  • [00:04:31] And I know you from emailing and DM-ing me over the years have found that helpful as well. So we talk about that. First, next we move into the business overview. Fundamentally, what does this company do? How do they make money? Who do they serve? And then we move into financials. We just look at a brief snapshot of how the company is performing financially.
  • [00:04:54] If you don't perform well financially. You're not going to be in business very long. So that's a very important aspect. Just a common sense thing that we need to look at as investors. And then to close out, we talk about some of the final thoughts and synthesis and valuation of the company and of the stock itself.
  • [00:05:14] And I like to kind of put things together. And wrap it all up at the end of the episode. So that is the structure for this episode. Now I do want to reiterate that I have started including chapter markers with every single episode. So if your podcast player supports chapters, it's as simple as just tapping on the segment of episode that you want to skip to, and your podcast player will automatically skip to that.
  • [00:05:41] So if you want to automatically skip to the financials. You just click on financials and you'll automatically jump to that section. Or maybe you want to go back and there is some interesting part of the story in the history section that you want to jump to. You can always click on the history section.
  • [00:05:55] So if your podcast player supports chapters, go ahead and check that out. I know a lot of you listen on Spotify. I don't think Spotify has that feature yet. Personally, when I'm listening to podcasts, I really like to use the pocket casts app that's pocket casts, C a S T S. And very small percentage of you listen to the show on that app.
  • [00:06:18] But I know they support that feature and it's a free app. So it's really easy to get and it just can help with jumping to different parts of the episode. If you don't want to fast forward 30 seconds every time you want to skip something or rewind manually. So check that out. Yeah. I, I have begun marking my chapters for every single episode that I release.
  • [00:06:43] So I hope you are taking advantage of that. Okay. So now let's get into the history of Costco. Where did Costco begin now? Honestly, I was not that familiar with Costco up until very recently. So it's kind of new to me. And I want to tell you more about how this whole concept came into being. So the first thing to know is that this membership model, Costco charges a membership to actually shop at their stores.
  • [00:07:13] You can't just walk in there and buy things, which is really interesting. You have to actually pay a membership fee. And the origin of the membership wholesale concept began back in the 1950s in California. And there was a man named Sol Price and Sol Price was this entrepreneur. Now up until this point, retailers had used a couple of different management techniques in order to kind of solidify themselves in their niche sometimes.
  • [00:07:43]People use attractive store designs. Sometimes they use advertisements to keep people in the stores, but no one really used this membership model as far as selling directly to consumers. The wholesale store as a general concept existed actually as early as the 1920s, but these were called quote unquote cash and carry operations.
  • [00:08:07] Now, what does that mean? These types of businesses were retailers that sold exclusively to businesses and these businesses only paid cash. So never on credit. And then they arrange for their own delivery of product from the wholesale warehouse, thus the cash and carry. So you're responsible for paying cash and for carrying it out of the store yourself.
  • [00:08:31] Now, these types of businesses were not open to the public. And they were, like I said, specifically designed for businesses, typically businesses who were buying in bulk, who just wanted a cheap price. And that was how the wholesale concept really began. But this was not open to the public. So in 1954, Sol price decided to pioneer this concept with consumers, namely federal government workers.
  • [00:08:58] And he started his business called fed mart, Fed Mart, sold discount goods to government employees, and they charged an annual subscription of $2 per year per family. So not too bad, right? You pay a little bit of a subscription and you get cheaper prices. Now this concept proved to be pretty successful.
  • [00:09:21] And then over the next few decades, he grew fed Mart to over 45 stores and 300 million in annual sales. So 300 million in annual sales. It's pretty good. Now, unfortunately, Sol was forced to sell the company in 1976, when new leadership took over and fed Mart eventually just kind of died out. It didn't have the right leadership and direction after Sol price left and Fed Mart eventually failed, but Sol Price.
  • [00:09:53] He was determined to start again, even though he had been forced out of his own company. He decided to create a new store. And this time he called it named after himself, his last name, the price club is what he called it. And interesting part of this story is I think it's interesting, not just when entrepreneurs start a business, but I want to know
  • [00:10:14] how did they do it? How did they actually obtain the funding in this situation? It was interesting because so obtained funding from a variety of sources, he had $800,000 from his own money. He got a million dollars in funding from local, California, small business owners. He got $500,000 from former Fed Mart employees actually, who helped back him.
  • [00:10:39] And then he combined all this money in order to start the new venture. Now, this is interesting because sometimes the funding for new company has to come from a variety of sources, notice that he was able to sell himself, sell his. New concepts to a lot of different groups of people who were familiar with him.
  • [00:10:59] He sold it to California business owners. Those are the people who he was going to serve with his business. He had his own savings, 800,000, not, not a bad amount of savings. And then he also was able to convince people who he used to work with to invest in his new company. So sometimes entrepreneurs are.
  • [00:11:19] Getting funding from all these different sources, because that's what they need in order to get something off the ground sometimes. So it's just an interesting tidbit there. So the first price club was created in San Diego, California. So even though sales were really good in the first year, the store actually lost several hundred thousand dollars and it wasn't profitable.
  • [00:11:40] So things got bad pretty quickly. And then Sol kind of put the brakes on, realize he needed to do. Some different things. He decided, you know what, I'm going to expand the scope of who can become a customer of the store. So you open the membership up to credit union members, utility workers, hospital workers, a lot of civil servant type of professions.
  • [00:12:06] He opened up his membership to them, not, not just government employees. So he raised more money by selling more stock in the company. Open the scope of who could become a member and then guess what the new tactic worked. And after a successful year in business, he opened up another price club in Phoenix, Arizona.
  • [00:12:27] Now the business continued to grow. Customers were appreciating that price club was really the exact opposite of what most stores were. It was all about low prices, three economies of scale. So the business expanded through the West coast and the Southwest, he kind of stuck in the California Arizona area, but because the company was so intense on.
  • [00:12:56] Owning the land underneath the buildings for their warehouses. They were hesitant to buy higher priced real estate over on the East coast. So the growth of the business actually was slower over there. So they kind of stayed in their lane over on the West coast. Now by the early 1980s. Guess what happens?
  • [00:13:15] This concept is catching on. Competition starts to arrive. Not only was there Walmart, hello, Walmart Sam's club that began to spread all around the United States, but there were other competitors like Kmart had their pace membership clubs, but the fiercest competitor of all was a young company called Costco.
  • [00:13:38] Now what was Costco? Costco was started by two gentlemen named Jim Senegal and Jeffrey Brotman in 1983, up in Seattle, Washington. Now Jim had previously worked with sole price at Fed Mart. That's how their stories started together. And he had become an executive vice president there before he left to start Costco.
  • [00:14:03] So Costco was very similar to price club. They borrowed heavily from the concepts that Sol price pioneered, but the difference with Costco is they differentiated themselves more by focusing on quote unquote recession, proof items like fresh food, baked goods, meat produce all sorts of food that people are going to buy.
  • [00:14:26] Anyway, no matter what now. The main benefit of shopping at the wholesale model is low prices. I mean, you're going up to a warehouse is not that pretty. You're paying a subscription to go in and buy things in bulk. That's the whole idea. So he built off of this concepts and said, all right, we're not just going to offer.
  • [00:14:49] Certain items in bulk, we're going to expand our offerings to sell things that your everyday person is also going to want. So maybe you go to a Costco, not just for your, say your business supplies, but maybe you pick up some fresh fruits and veggies or some meat or dairy. And you're kind of this one you start to become this one-stop shop for your shopping needs.
  • [00:15:16] And that was unique in the wholesale model. At this time, there weren't really any other companies doing this. So it's innovation like that, that helped Costco compete with price club. Now Sam's club from Walmart. They were also growing rapidly now because Costco and Sam's club were not as focused on actually owning the real estate.
  • [00:15:38] Their warehouses were built on. They were able to grow faster throughout the entire United States. And they gradually started taking away market share from price club. Now price club eventually did expand into the East coast in the late 1980s, but it was too late Costco and Sam's club. They already grew stronger by then.
  • [00:15:58] They each had more warehouses than price club. Now Sam's club in particular grew a lot. And by the early 1990s, they started to eye their competitors for a potential acquisition. So you have Walmart coming up and starting to get more aggressive and saying, Hey, we want to start buying up one of these companies.
  • [00:16:18] Now, the price family that owned price club, they didn't want to sell the Walmart. And so they declined an offer from them. But you know what their earnings, they started to drop significantly and they actually had to spin off their real estate, that precious asset that they were so focused on owning they ended up having to spin it off and sell it just to stay afloat and fund expansion in.
  • [00:16:43] California, which was actually the territory that was oversaturated. They already had so many stores there. So the business just started to become mismanaged a little bit and they started faltering. And they turned down that Walmart offer, but they eventually agreed to a merger with Costco. They kind of didn't have any other choice.
  • [00:17:04] So this merger created price. Costco was the name of the company, just a mashing of price and Costco together. And that happened in 1993. And the thing is both companies. They operated independently, but they shared resources like scanning technology. Costco, the whole deal was they would focus on the domestic operations in the United States and then price would focus on the international operations because they had some stores outside of the United States already at that time.
  • [00:17:36] Well, things did not really go well. Overall sales struggled. And then this quote unquote merger, it was really two separate companies that half-heartedly attempted to work together. That's what happened. So Robert Price, who was sole Price's son who was running price club at this point. He really disagreed with Jim Senegal on how the company should move forward.
  • [00:18:01] They kind of butted heads. And so just one year after this merger price parted ways with Senegal and price decided to take over the commercial real estate interests, which were spun off again, I guess the price family had this thing with owning real estate. So they were really focused on that. And they also got some of the warehouse locations.
  • [00:18:21] But the total value of what was spun off was only 10% of the overall earnings of the combined company. So really the primary price Costco business was still held in tact. Now with that kind of out of the way, with a clearer path for growth and expansion Senegal focused on the warehouse business, the business that he initially started out on.
  • [00:18:45] And he was able to turn sales around. So he kept expanding the business. And by the late nineties, 1997, the company was named once again to just Costco and they rebranded all of the old price club stores. And then they began to grow more from there. They became more focused and they became the dominant wholesale retailer in the United States.
  • [00:19:11] And in fact, one of the most dominant in the entire world, So that's how Costco came to be, what it is today. All right now, let's turn our attention to the business overview. What does Costco do today and how do they make money? So the Costco business today is huge as of 2021. They own 795 warehouses worldwide.
  • [00:19:42] Now about 70% of those are in the United States. 13% are in Canada. And then the rest they're spread out through a few other countries like Mexico, the United Kingdom and Japan. Now they employ over 250,000 people worldwide. That's a lot of people by any measure in the business world. If you're employing.
  • [00:20:06] Literally multiple hundreds of thousands of people. That's a huge organization. So Costco is huge. Now the business model today, it's based on a lot of the same principles that sole price pioneered, there are large industrial warehouses with no frills items that are sold in bulk, minimal advertising, and then an annual membership fee that's charged to customers.
  • [00:20:32] So speaking of customers. Costco has over 58 million of them. That's right. 58 million customers or members. And I can actually speak about this personally because I actually just recently became a Costco member myself. So I've got some of the Costco, like materials here in front of me. And it's amazing because they offer so many different types of things.
  • [00:21:00] And my wife and I were like, you know what, let's go check out Costco. We never really. Looked into it. We've known people who have the membership, but it just wasn't really a thing that we were exposed to either growing up or in our adult lives so far. So we went by and it was like, you know what? Let's, let's check this out.
  • [00:21:19] So we decided to give it a go. And the way it works is that there are two tiers of membership. There's the gold star membership and then the executive membership. So they cost $60 and $120 annually, respectively. So 120 for the executive 60 for the gold so for me and my family, we went with the gold star membership.
  • [00:21:43] Now the executive one. They give you some perks as far as cash back. But when I calculated the anticipated amount of spending that my family is actually going to do there over the coming year, it just didn't seem worth it to upgrade. So I could definitely see us upgrading in the future though, once we have more mouths to feed and we shop there more, I think the value proposition is great, especially.
  • [00:22:08] For large families. I think that's where Costco really shows this value. If you have one, two, three, four children, and you're feeding a huge family, then buying in bulk, especially for food and toiletry type items, household items, that's a big win. So the company's model, it's, it's all about low costs. It's similar to Walmart's culture.
  • [00:22:33] The one interesting thing about them is on sunny days, Costco will actually turn some of the lights off in the building in order to save electricity and they opt for the use of skylights in their stores. So have you ever been inside a Costco? If you were to look up at the ceiling, you would see a ton of light bulbs, but you'd also see a bunch of skylights scattered.
  • [00:22:58] All the cross, the roof of the store. And that actually helps keeps the electricity costs down because sometimes the sun is bright enough and it can just shine through and basically light up the store. So that's kind of the way that Costco management thinks they're constantly trying to ring out a couple extra cents of, or a few extra dollars of costs in order to save the customers money.
  • [00:23:22] So the profit margins, as a result are really low they're about 2% and thing they do is they commit. Not to marking up products about 14% over costs. So they place these limits on their margins because they want to make sure that they're competitive and they actually have the lowest cost available now for their Kirkland signature label, which is like their brand name for a bunch of different products.
  • [00:23:52] They keep it at 15%. So another way that they keep costs low is by focusing on having a limited and really tightly controlled inventory. So think about the typical store. The typical store retail store they'll sell thousands of items, probably tens of thousands of items on that order of magnitude. So Costco only sells 3,700 individual products, which is very, very few.
  • [00:24:21] Compared to their competitors. For example, Walmart, they have over 140,000 items that you can buy at Walmart over 140,000. It's virtually anything you want virtually anything you need for your household food products, toiletries. Car parts, batteries, all sorts of things, clothes, electronics, toys for kids.
  • [00:24:46] Walmart sells it all and that's really their thing. But Costco is kind of the opposite approach. They're like, all right, we're going to be just as big as Walmart, but we're going to focus on having few things because we would rather sell things in bulk and sell them at at really low prices per unit. And that's kind of their strategy.
  • [00:25:09] So one thing to note right now is Costco is still very much a brick and mortar retailer. In fact, only 4% of their revenue comes from e-commerce. And I think that's a huge opportunity when my wife and I became members recently, I saw that they have a Costco app and I thought, you know what? I probably just need to download that because.
  • [00:25:31] I might be able to speed up some shopping, or we might be able to speed up a lot of our shopping just by buying online through their portal. And so I think this could be a big opportunity for them just, just based on the general trends of the internet. Basically taking over every business in every way.
  • [00:25:52] So over time, Costco has expanded their offerings and services that they provide. I mean, 3,700 pales in comparison to over 140,000, but they do offer a lot. So in addition to food clothes and home equipment, they also sell things like jewelry, wine. Alcohol electronics. I mean, even have an optometrist onsite and a gas station, which offers members discounts over your typical gas station prices.
  • [00:26:23] So there are five categories of the business. Overall. They sell food and sundries which are things like paakged, food, alcohol, cleaning supplies, fresh foods, they sell hard lines. These are things like electronics. Your appliances, patio furniture, they sell fresh foods. So the non packaged stuff, soft lines, which are clothes and small appliances.
  • [00:26:54] And then there's the ancillary category, kind of the miscellaneous category, where they sell gasoline. They have a pharmacy, those kinds of things. So those are the five categories of things that Costco sells. Now, surprisingly to me, actually, 11% of the revenue comes from the gasoline business and that's surprised me a little bit, but then I thought, you know, what, who doesn't want cheap gas?
  • [00:27:18] And it makes sense actually filled up at a Costco gas station the other day. And the reason I did. So even though I wasn't fully empty and anything like that, I thought, you know what? Why not? Like. We're already here. We're going to go shopping anyway. We might as well get the discount and fill up now. And I think that's exactly how Costco has designed it is to make sure that things are as convenient as possible for their members, so that people ultimately spend more money with them over long periods of time.
  • [00:27:50] And so, yeah, it was a total win-win. I got cheap gas and Costco got additional sales. They wouldn't have otherwise gotten. If they were focused exclusively on what's inside of their building. So I think that's a pretty interesting play there. And then Sam's club also does the same thing too. If you're wondering.
  • [00:28:10] So one interesting thing about Costco also is this Kirkland signature brand. So reportedly the Kirkland signature sales actually grow at a faster rate, then the Costco sales overall. So that's kind of interesting, right? Cause it tells you that that Costco has created its own brand successfully, that people have a certain affinity for.
  • [00:28:36] So they have so many services. It's a bit mind boggling. I mean, I have some of the materials here in front of me right now. I mean, they've got, they've got a business related service. They have Costco travel. There's a Costco auto program. There there's so many things. And actually this Costco auto program, I didn't realize that they're the second biggest car service in America.
  • [00:29:00] So they work with dealers around the country. And then they have a low prearranged prices for their members. So that's pretty interesting. I had no idea you could buy cars through Costco. So all of these things are, are just amazing. And then they also have this food service. They have a food court inside the store, which is another way again, of keeping people inside and drawing people back.
  • [00:29:23] Like, Hey, at least I'm going to get cheap food while I'm there. I mean, you could buy this long, hot dog for a dollar 50 cents. A dollar 50 cents. I mean that in America, that's super cheap for a hot dog and my wife and I got one the other day and we just split it cause it was so big. So the cost per meal per person in that case was 75 cents.
  • [00:29:49]You know, call, call me a cheapskate whatever, but it honestly was just a lot of food. So they have all these different things in order to provide value. And they made recent improvements to their business too. They've expanded in areas that a lot of American businesses have struggled to expand in.
  • [00:30:10] They just opened their first location in China, over in Western Shanghai. And that was a really big deal because China is just not as open to foreign companies opening up on their soil, but Costco did so, and they were amazingly successful. They had a lot of signups. Immediately upon opening. And then another thing that Costco has been doing is they've been focusing on increasing their presence with premium brands.
  • [00:30:39] So these are those brands that people are going to pay a little bit more for. So brands like Apple, Columbia sportswear, Sony. So these kinds of brands are partnering with Costco to have their products sold in the store. And that also has the benefit of drawing more people like, Oh, I can get my Apple AirPods at Costco.
  • [00:31:01] Oh, I can get my, my nice quality winter jacket at Costco it's not just off-brand stuff. It's quality stuff. And then there's also a thing called the Costco locker where. Items you order online or stored for you to pick up similar to the Amazon locker concept. So that sounds kind of cool. And I might give it a try.
  • [00:31:25] Okay. So now let's talk about the financials now, as always on this show, I don't like to get bogged down too much in the numbers, but I do want to provide a snapshot in time of what the trends are with some of the more important numbers. For this business. So what we'll be doing for the sake of comparison is looking at the years, 2013, fiscal 2013 and fiscal 2020 a seven year period, which I think is a long enough period to get some idea of the basic direction that the businesses finances are going in.
  • [00:31:59] So first let's look at the sales, the top line. So in 2013, Costco had just over 100. Billion dollars in sales. That is huge. I mean, that is massive amount of sales for any business and for a retailer to be dominating that much. That's very impressive. Those are very impressive numbers. By 2020, they grew their sales to over $160 billion in sales.
  • [00:32:28] Massive massive amount of sales and that's pretty strong growth. That's about a 7% annual growth rate in sales for a company that was already a hundred billion dollar in revenue company. Think about that. I mean, 7% growth that may not seem super impressive. But for a company that huge that's I think that's very impressive.
  • [00:32:49] Now let's go down to the net income. How much profit did they make at the end of the day? Now, remember the margins in this business are super small, now remember how I talked about 2% margins a few minutes ago. Well, here's where you see that come into play the hundred billion in sales. Guess what? That translated to 2 billion in net income.
  • [00:33:09] So they made $2 billion in 2013, fast forward to 2020. That's doubled to 4 billion. So they've actually increased their profits at a rate of about 10 and a half percent annually, so better than the sales growth. And that is through that relentless focus on cost management. Things like turning the lights off in the middle of the day when the sun is out, those kinds of moves.
  • [00:33:33] They may be small individually, but added up over time and over the scale of the enterprise, they can save a lot. And so that cost management has been really good. Resulting in double digit profit growth for a business that is massive already, very mature business. Let's look at the earnings per share though, the earnings per share.
  • [00:33:54] That's what you and I actually get to keep as owners as our share of the profit. The amount of money in earnings per share, went from about four and a half dollars per share somewhere around there to about $9 per share. So again, it doubled 10% annual growth rate in earnings per share, nothing to. Crazy there.
  • [00:34:14] That makes perfect sense. Given the actual growth of the earnings of the business. So this is what we would expect now turning our attention now to the balance sheet. This is the portion of the business's financial statements that tell you what the business owns versus what the business owes. And one of the things that I like to look at is the cash balances.
  • [00:34:36] How much cash do they have on hand? Well, they went from about four and a half billion dollars in 2013 to over 12 billion in 2020. That's a pretty nice increase in cash. And frankly, not many companies of this size are increasing their cash balances. Some have done so recently because of the Corona virus pandemic, just for the sake of survival, but not many have nearly tripled their cash balances over a several year period.
  • [00:35:03] So that's something that I like to see. Very good there. Very good. As far as the long-term debt that the business owes, they went from about 5 billion to about seven and a half billion, a little bit of an increase it's held relatively steady, actually over the past several years, I think just in this past fiscal year, they decided to borrow a little bit more, but nothing too concerning there that's, that's only two years, less than two years worth of profits in debt, which I think is a very strong.
  • [00:35:33] Relatively strong balance sheet. Now the big costs for Costco, I want to mention this is their merchandise costs. This is the reason why their margins are so low. Costco has to buy and move a ton of inventory because that's what it sells to customers. So their merchandise costs are on the order of around a hundred billion, actually just over 90 billion back in 2013.
  • [00:36:03] And then they've risen to over 145 billion in 2020. So you have this big increase in merchandise costs. And you would, you would expect that with inflation, with the natural rise and the cost of raw materials to make AirPods and jackets and clothes and raise cattle and chickens, and all of the things that go into the products that you and I buy, it makes sense that those prices would increase, but it's, it's encouraging to see Costco.
  • [00:36:32] Able to keep up with that and still grow their profits at the end of the day. And then as far as financials in the cashflow statement, this is the money that actually moved into and out of the business. So as far as operating cashflow, how much did the business itself generate? About three and a half billion.
  • [00:36:53] In 2013 and then just under 9 billion in 2020, again, pretty solid growth for businesses size they're investing cashflow. It tends to be between two and $4 billion a year. That gets reinvested into building new stores and expanding their footprint. And then with financing cashflow, they usually don't.
  • [00:37:16] Have a lot of money that's getting raised in debt or being bought back and share repurchases or anything like that. Nothing really special going on here. But one thing I did want to note in 2013, it was actually a very special year because Costco borrowed a bunch of money and then they paid out a one-time special dividend.
  • [00:37:39] Of over three and a half billion dollars. This is a company that pays out special dividends. Now, speaking of dividends, how much did the company pay out? Well, they paid out three and a half billion in 2013. As I mentioned in 2020, the number was just 1.4 billion, but that's a little misleading because.
  • [00:38:00] That special dividend makes it look like the dividends actually decreased a lot over time, but they really didn't decrease much over time. So the dividends per share, they had a $7 per share special dividend in 2013, without that special dividend, it would have been a dollar and 17 cents. Compare that to $2 and 70 cents today.
  • [00:38:21] That gives you about a 12%, 12 and a half percent annual growth rate in the dividend. So the dividend has actually been growing pretty strongly in the low double digits. It's just that sometimes once in a blue moon, they'll give shareholders this huge treasure chest of money and pay out this special dividend.
  • [00:38:40] So that's something to look out for too. Management is rewarding shareholders, and then the shares outstanding for this business. Nothing really going on here. The share count has been relatively consistent. Over the years at around 440 million shares. So nothing too crazy there. All right. So let's wrap this up by looking at the valuation and some closing thoughts.
  • [00:39:04] How do we put all this information together? How am I thinking about this business after going through all this information? Well, I want to turn your attention to page 20 of the annual report because it States Costco's philosophy. On pricing "our philosophy is to provide our members with quality goods and services at competitive prices.
  • [00:39:30] We do not focus in the short term on maximizing prices charged, but instead seek to maintain what we believe is a perception among our members of pricing authority, on quality goods. Consistently providing the most competitive values ". So I read that and I was like, okay, management's got something going on.
  • [00:39:59] They seem pretty focused on really just bringing it as far as value products and services to their customers. So they're really, really focused on like long-term customer retention, making sure customers are happy with what they're buying and not, not kind of cheaping out and just charging them a lot initially and then kind of leaving them high and dry, but giving them a good value up front so that they keep coming back over and over and over again.
  • [00:40:31] Keep paying those membership dues every year, keep buying their gasoline, buying their food, buying their clothes, et cetera. So another thing that is encouraging about Costco is even though it's a very mature business, it's comparable sales. That is the sales that existing stores have year over year.
  • [00:40:53] They're actually growing. So they're comparable sales are between four and 7% per year. Depends on the year. In 2019, it was 6% for example, in recent history. And then if you exclude the effects of gasoline prices and currency effects around the world, they're relatively stable. Growth across locations worldwide.
  • [00:41:17] And then the overall store count growth is about two to 3% annually. So this is definitely slow growing. They're just kind of gradually opening new businesses here and there they're pretty much saturated in the United States already. They're all over the place. So that's something to consider, but you know, you add up the same store sales growth of 6% with overall store count growth of two to 3%.
  • [00:41:44] That gets you earnings growth of around eight to 9% somewhere around there. Now the gross margins. Remember we talked about net margins being just 2%, but their gross margins are actually around 11%, but they're constantly under pressure because of supplier costs. Remember those merchandise costs we talked about.
  • [00:42:03] Gross margin is the sales minus the merchandise costs. And that is the biggest driver of Costco's costs. So again, we have to look out for that, but I think that Costco, they have proven based on the numbers that they can consistently manage this. They can actually still manage to grow the top line and keep that gap between income and expenses or rather sales and expenses.
  • [00:42:31] Wide enough that they can still make money and still make more money over time. Now I like the relatively large cast balance. Now $12.2 billion that may not seem like much given for a corporation that has over $160 billion in sales. But I think it's impressive given the high amount of costs associated with this business, when you have low margins.
  • [00:42:55] It's really hard to conserve cash. It's like telling a person who makes $30,000 a year, but spends $28,000 a year that they should save. 50% of their income or save like a huge amount of their income. Like maybe they could do it, but it would take massive changes in their lifestyle in order to save that much because you just don't have that much to work with.
  • [00:43:21] So building up a big cash balance, that's pretty impressive to me that Costco is able to do this. So what do we have here? We have this large business that culturally seems like a wonderful business and I might add. One of my favorite investors of all time. You've heard me mention him many times on the show in the past.
  • [00:43:43] None other than Charlie Munger himself, he's still alive and kicking. And he himself is on the board of directors of Costco. And he has been since 1997. So that, to me, that tells me a lot right there that Charlie Munger would agree to be on the board of this company. To me, I'm like, Oh, this must be an excellent business.
  • [00:44:02] Charlie Munger is on the board. So that, that's a huge thing for me personally. And then another thing about them is that. They're also wonderful from the perspective that they continually grow cashflow as well, even though their comparable store sales fluctuate year to year, their revenue and profit growth tends to remain pretty consistent it's somewhere in the eight to 10% range.
  • [00:44:26] And that makes sense. When you add up the same store sales growth with the new store growth, as I mentioned earlier, but another part of Costco's secret sauce, I think is their membership model. The subscription model. I see the subscription model continuing to be a huge boon for future profitability. I mean $60 a year.
  • [00:44:49] That's not bad, especially when you're paying the shop at a place where you can regularly get great deals on everyday items. So we were there the other day and we got this pack. It was like four frozen pizzas. For something like $12. Now that's crazy. That's $3 per pizza, not pizza slice, but like a whole like medium size pizza.
  • [00:45:12] If you divide that up per slice, that's three eights of a dollar, which is what is that? That's, that's a little less than 50 cents. Maybe like 40 something cents per slice. That's that's insane. So deals like that. They're everywhere at Costco. Now membership increases they've happened in the past. And I think that that's going to be a good way to stabilize and continue to grow Costco's earnings going forward is that they're going to be able to increase their prices with no problem in the future because their membership prices are pretty low.
  • [00:45:45] I mean, $60 per year. That's not bad. That's $5 a month. That's less than the cost of Netflix. We're going to six. So as of right now, their retention is really good too. About 88% of members retain their membership from year to year. And if you look at just the U S population of Costco's membership, it's actually even better around 90%.
  • [00:46:10] So they're really good at keeping the people that they convinced to get a membership with them. All right, let's talk about price real quick. Right now the share price. As I record this, it's around $370 per share. Now compare that to $9 in earnings over the past 12 months. So that's a price to earnings ratio of over 41, 41 times earnings for a retailer.
  • [00:46:39] I mean, damn. It's, it's pretty clear that Costco is. Good at what it does. If, if you've gotten this far in the episode and you haven't seen that yet, then maybe go back and listen again. But it's pretty good at what it does for a retailer. I mean, they're a massive company that still manages to grow in the low double digits, but paying 41 times earnings for a company this mature without some significant growth component.
  • [00:47:08] I don't think that's how you get rich. I believe that shareholders hold their shares. For long period of time, if they do that, they're probably going to do okay. But you might lag the market because you might face price, earnings, ratio compression. And the reason that I think that that is a possibility, in fact, maybe a decently strong one is that historically when I looked at the data, Costco has mostly traded in a 17 to 30 times earnings range.
  • [00:47:42] So I'll wait for a better price, but I do think that this is a great business. There's a reason Charlie Munger is on the board. There's a reason they've managed to actually compete very successfully with Walmart. And actually Walmart now has been struggling in recent years with their Sam's clubs and Costco.
  • [00:48:00] They just keep growing. They they're able to actually have a strong presence. In countries other than the U S which has been a problem for a lot of businesses that have saturated the United States, but have not succeeded internationally yet the international growth stories is maybe one of the, the better components of the future here for Costco, because they have proven themselves are ready, but they're not in very many markets yet.
  • [00:48:26] They still are in very select international markets. And then that, that China. Presence as of last year is, is also really encouraging. And then, like I said, the pricing power of that membership model is great. So I would definitely value this way more than your typical run of the mill retailer, but at the same time, 41 times earnings is just for a business growing at 10% that doesn't have a significant, super significant buyback program or super significant dividend.
  • [00:49:01] Is something that I am a little more skeptical about as far as margin of safety. That being said, I think that Costco is amazing. They have been great to shop at so far, just as my personal experience as a customer. But I think that as an investment, they could also be amazing as well. I just the price again, with a lot of these large cap companies right now, the market has been going up for several months now.
  • [00:49:26] Without any major corrections and Costco has been going along for the ride too. So 41 times earnings it's a lot, but of course you make the decision for yourself. It can be beneficial to own a business that is this excellent. If you're willing to own it for decades and decades, because eventually the quality of the business will kind of counteracts any significant price.
  • [00:49:54]Compression or valuation compression. So that's, that's something to consider there. So those are my thoughts on Costco. I hope you enjoy this episode. I did a lot of research for this aside, from just my typical research, but I actually went to Costco and shop there myself and just kind of notice things and looked around and just spend some time walking around and shopping and.
  • [00:50:17] And I learned some things. So I hope you enjoyed the results here in this episode. And that is what I got for you today. Thank you. Thank you so much for listening. As we continue on into 2021. Again, I am so excited for this year. It's going to be an amazing year and I hope it's amazing for you too. If you want to help out the show, please share it with a friend.
  • [00:50:44] If you happen to listen. On Apple podcasts, please rate and review on Apple podcasts. That always helps the show out. I saw a couple new reviews this past month, so thank you so much for those new reviews. And yeah, keep them coming. Keep the questions coming. The comments you can reach me on Instagram. Just send me a direct message at stock storyteller.
  • [00:51:07] That's at stock storyteller, or you can email me at Alex at stock stories, podcast.com. Always love hearing from you. All right with that. I will see you next time.
  • [00:51:40] The information presented here on stock stories is for informational educational and entertainment purposes only. You and you alone are responsible for your investment and financial decisions. Please consult an appropriate tax legal or financial advisor that can analyze your specific situation in the context of your goals and circumstances.

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