Costco – The Moat Is The Unique Corporate Culture

Costco (COST) is a US retailer, and a pretty unique company because of these reasons:

  • A simple business model where members pay a membership fee upfront. Items sold have only a tiny profit margin. Thus, the main income is from the membership fee.
  • Costco receives a “float” when the members pay in advance. This is like a perpetual interest free loan with no strings attached – no covenants.
  • The membership fee is placed as a current liability in the balance sheet when in fact this is a perpetual liability. Thus, working capital is in reality even stronger and provides more funds for organic growth.
  • Not only are the members funding parts of the business, but also to some degree the suppliers as well. This is because Costco turns around the inventory faster than it pays the suppliers.
  • Clearly Costco offers a lot of value for its customer, otherwise they would not renew. Retention rate is 90%.
  • Very able management (recruited internally). Charlie Munger is on the board.
  • Skin in the game: All directors and executives own in total 952,000 shares worth about $235 million. Biggest shareholder is Craig Jelinek, CEO, with 311,000, and second Charlie Munger at 184,400. Furthermore, Berkshire Hathaway owns 1% of the company.
  • Some years ago Munger said Costco is the company he admires the most.
  • Costco is recession proof: The stock had a much lower drawdown than the market in 2008/09: 36% vs. 50%. Why is this important? The less a stock falls, the higher the base of the recovery. Because of the compounding effect, I always prefer stocks which are as less cyclical as possible.
  • In 2009 net sales shrank 1.5%, net income fell 15% and comparable sales fell 4%. But overall, Costco gained market share during the crisis.
  • Able and satisfied employees: Costco has committed to not only low prices, but also high wages. Costco pays and treats its employees fairly, and thus has a low turnover and higher productivity.
  • The Kirkland Signature: This is Costco’s own brand and only sold at Costco. This accounts for 25% of the sales. The products are manufactured only for Costco, and done for products where Costco assumes it can do it cheaper and better on its own. Customers know the quality is just as good as anything else. The Kirkland label is synonymous of quality and value.
  • Costco has leverage and scale. It can buy in bulk and negotiate low prices. The prices offered by Costco can compete with any online business, like for example Amazon.
  • Growth is solely organic. There is no risk for ill-fated M&A. Growth are opened gradually and in a planned manner.
  • The balance sheet is strong and free from goodwill and intangibles. Long-term debt is only 1x EBITDA.
  • Both the land and the buildings in the US are owned by Costco, thus most likely “hidden” value in the balance sheet.
  • Costco prefers paying a dividend to buying back shares (based on their actions). The dividend was initiated in 2004 ans its been increased ever since with special dividends now and then.
  • Despite being a huge company, I still believe the runway is long due to its international expansion.

Because of all the positives, Costco always trade at high multiples. Current valuation is a P/E of 37. This is the highest its ever been, perhaps rationally so because of the very low interest rates. I believe Costco is “immune” to Amazon because of its membership structure and competent management. Costco’s model is still thriving and has shown resilience.

Conclusion

The main asset in Costco is its culture. They are in the market to serve their members and their competitive advantage is the goodwill from the customers. The biggest risk is that management gets greedy and lacks trust among the members.

I believe a company serving its customers fairly does more for mankind than any charity. Costco is most likely such a company. This is the main argument for investing in Costco. As long as this culture in intact, Costco will do well.  Costco offers a very simple business model but yet not so easy to execute. You need a long-term focus and deep in-grained corporate culture to deserve the trust from the members. Costco has accomplished that. The only negative is the valuation.

 

Disclosure: I am not a financial advisor. Please do your own due diligence and investment research or consult a financial professional. All articles are my opinion – they are not suggestions to buy or sell any securities.  

(This article was published on the 11th of September 2020.)

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