If you ask investors why Costco is so dominant, you will likely get answers such as low prices, strong cost control, consumer-friendly returns practices, membership program, and cheap gas, hot dogs, and rotisserie chicken. All of these are important elements to Costco’s business model, but they pale in comparison to one factor: Costco’s low stock-keeping unit (SKU) count. This is the single-most important driver of Costco’s business, and what truly makes their model impossible to replace.
The key difference between Costco and other major retailers such as Walmart is that Costco carries a very low selection of products, around 4,000 SKUs in-store versus about 120,000 at Walmart. Instead of having 4 brands of ketchup, Costco will only carry one (at my local store, it’s French’s). Using ketchup as an example, this has several implications:
- First, Costco sells significantly more French’s ketchup than anyone else, since anyone who needs ketchup can only buy French’s.
- Second, because Costco members are conditioned to shop at Costco for all their daily needs and more importantly, trust Costco’s merchandise to be high-quality products, they will buy French’s ketchup without considering alternative brands.
From Costco’s perspective, this means that its negotiating power with suppliers is on a different level from even other retail giants such as Wal Mart. Costco is not merely stocking French’s ketchup, it actively sells French’s by making it the only option for ketchup. At Loblaws or Walmart, French’s needs to compete against other ketchup brands by spending on fancy labels, in-store displays, or brand advertising.
To put this another way, in theory, French’s can be profitable on sales to Costco as long as it can sell above manufacturing cost since it does not need to spend on marketing to drive sales, while French’s needs to cover marketing costs on sales to other distributors. This is Costco’s true moat: the ability to negotiate pricing down to production cost due to their massive customer base of 116 million cardholders buying a limited number of SKUs.
As Costco builds new stores, adds new members, and drives traffic and sales through cheap gas and hot dogs, suppliers sell more and achieve greater economies of scale on fixed costs, allowing Costco to lower prices even more and further improving their competitive advantage. Today, given Costco’s size and strong reputation among members, it is impossible to think of a business model that can achieve lower pricing sustainably.
Costco’s ability to aggressively negotiate savings for members is true not just for products but for services as well. A good example of Costco’s power is the dispute with American Express for Costco’s co-brand credit card in the United States during 2016. At the time, Costco represented 10% of American Express’s volumes but ended up switching to Visa with Citigroup as the provider after Citi/Visa offered an unprecedented 0% interchange rate on purchases at Costco along with very generous benefits to cardholders. American Express and Visa are powerful companies but had to offer significant concessions for the right to access Costco’s customer base, which Costco passed on to members through cost savings.
Costco is one of those “unicorn” businesses that have a truly irreplaceable competitive advantage with a management team that is solely dedicated on reinforcing every element of its moat, and we are thrilled to own Costco stock for the long run.
Quick thoughts on Costco’s valuation
The most common objection to owning Costco’s stock is valuation, with shares currently trading at 40x consensus earnings versus about 19x earnings for the S&P 500.
In Costco’s defense, there are several reasons why I think Costco’s valuation is more reasonable than it initially seems:
- Costco is a terrific, recession-proof business with a very durable competitive advantage.
- Costco has very low leverage both financially and operationally, with a net cash position on its balance sheet and owning rather than leasing its stores, which depresses near-term cash flow but provides greater future upside and stability.
- Costco runs at a negative working capital cycle such that cash flow is typically higher than reported earnings.
- Costco has a long runway of growth. Costco’s share of retail sales in the United States is still low-single digit percentage, while Costco is in the early innings of store growth internationally in places such as Europe, Asia, and Australia.
- Costco screens as a defensive stock given its track record of dividend growth and sector classification as a “consumer defensive” company. Such companies tend to demand premium valuations given broad ownership from ETFs and the perception that they are recession-proof.
Most importantly, Costco is playing the long game. The management consistently prioritizes the long-term sustainability of the business over near-term profits. One example is consistently choosing to lower prices rather than take higher margins even when possible. Another example is their industry-leading salaries and benefits for employees. Costco’s reported earnings could be significantly higher, but at the expense of customer loyalty and labor relations. This is compounding at its best.
On an enterprise value and cash flow basis, Costco is no more expensive than many other high-quality, growth businesses while having a significantly larger moat and defensive characteristic than basically any business I’ve studied. We are happy to be shareholders of Costco and expect Costco’s earnings, moat, and share price to be higher over the next 5, 10, and 20 years.