During our fourth quarter portfolio update, we profiled portfolio holding, Costco (COST). Below is a replay of our live commentary on the company from our quarterly portfolio update webinar and an excerpt from our QUARTERLY LETTER.

Costco

There are a handful of events that drive major changes in people’s shopping routines. Two of these are moving and having children. Naturally, when you buy a new house or have kids, retailers pepper you with emails and mailers containing valuable coupons and offers because they want to become a part of your new shopping routine.

It turns out that a global pandemic is another one of those routine-altering events. In early 2020, as stay-at-home and quarantine orders rolled out around the country, shoppers flocked to Costco to load up on essentials like paper products and food and non-essentials like TVs and alcoholic beverages (or maybe these are “essentials” during a pandemic?).

 

During this abnormal period, Costco proved and reinforced its membership value proposition. If you want your pantry to be well stocked and limit your shopping trips – all the while getting great value for your money – Costco showed it is the place to go.

Membership loyalty, already strong before the pandemic, continued to increase well after quarantines and stay-at-home orders were lifted. A recent survey by Evercore ISI showed that between 2020 and 2021 Costco gained loyalty across every tested demographic by age and income except for incomes below $45,000. Notably, its biggest loyalty gains came from the 18 to 34 and 35 to 54 year old age groups and incomes between $45,000 and $74,999.

The beauty of Costco’s business model is its simplicity. Customers pay an annual fee to become either a Gold Star (currently $60 in the U.S.) or Executive ($120) member. Executive membership has some additional benefits, most notably a 2% reward on purchases. To shop at a Costco warehouse, you need to purchase one of the two memberships, whether you’re a household or a business shopper.

Costco, in turn, works for the member by getting its best price on quality items and then marking them up at a flat rate. For most merchandise, Costco marks up its products by 11% over cost; for its private-label Kirkland brand, the mark up is between 14% and 15%.

There are typically 4,000 items (“SKUs”) in a Costco warehouse at a given time, compared with 50,000 or even 100,000 items at other major retailers like Target and Walmart. There are a few benefits to having less SKUs. One is that there are only a handful of products that you can reliably find with each visit. This creates a “treasure hunt” mentality for Costco shoppers which encourages them to load up when their favorite items are in stock. Part of Costco’s brilliance is its ability to convince you to keep its inventory at your house.

A secondary benefit is that, as Costco grows its membership base, it generates more revenue against a smaller number of SKUs, giving it more bargaining power over suppliers. This enables Costco to get even better prices for its members, which it fully passes onto them, further proving the value proposition of being a Costco member.

Importantly, Costco could press its bargaining power advantage too far and mortgage its moat, but it is known for being a good partner to suppliers. Costco’s business model incentivizes this behavior. Because it makes most of its profit from membership fees rather than merchandise sales, Costco doesn’t have to continually squeeze suppliers to get an extra penny or two.

Costco could, of course, decide to not pass on supplier savings to its members or squeeze its suppliers for extra profit and post a much higher earnings per share figure, but this short-term gain would result in long-term pain as it would break the virtuous cycle it’s built among its stakeholders over the last 40 years.

Costco’s virtuous stakeholder cycle begins with its employees. The company has long paid its warehouse employees well above the retail average and offered health insurance and benefits as well. Back in the early 2000s, in fact, some investors and analysts bemoaned the fact that Costco was so generous to employees and demanded management cut back to boost profits. Costco held the line and showed the doubters that its model not only was the right thing to do but led to far better shareholder returns than produced by other retailers.

The company’s success has not gone unnoticed, and competitors have tried numerous ways to attack its moat, but Costco has endured the challenges. Beyond other warehouse models like Walmart’s Sam’s Club and BJ’s Wholesale, investors have at various times in the last decade grown nervous about digital competition.

The day Amazon announced its acquisition of Whole Foods in June 2017, for example, Costco’s trading volume increased more than 13-fold compared to the day before the announcement. And over the next week, Costco’s stock fell over 15%. It’s easy to see why investors might have been spooked by the acquisition. Amazon’s Prime membership is many times larger than Costco’s and if Prime members could now order groceries from Whole Foods, why would Prime members need to keep their Costco membership?

Another digital competitor, Boxed.com, was founded in 2013 and offers bulk-sized deals like Costco with the added convenience of mobile ordering and delivery. What’s more, no membership fee is required to purchase from Boxed.

Key to understanding Costco’s advantage against digital competition, however, is that Costco doesn’t sell convenience and its members are, by and large, not seeking convenience. What Costco sells instead is permission for frugal people to spend money and not feel bad about it. You might put too much in your cart at Costco and be shocked by the bill at the register, but you don’t feel like you got ripped off. Indeed, Costco members will often add, “I got it at Costco,” when telling a friend about a big purchase they just made as a sort of justification for their splurge.

Nevertheless, e-commerce is a big opportunity for Costco. In March 2020, Costco made its largest ever acquisition, buying logistics company Innovel Solutions for $1 billion from the parent company of Sears and Kmart. Innovel had distribution warehouses and last-mile delivery and installation services that Costco has leveraged to improve its delivery offerings to members. E-commerce is a better way for Costco to sell big and bulky items like refrigerators and washer and dryers, which typically do not move quickly on the warehouse floor and take up a lot of space.

Two additional benefits of expanding its e-commerce operations is that Costco can better connect with members who may not live near a warehouse. If you live 50 miles from the closest Costco, you may shop there once every month and not find an Executive membership necessary. However, if you can put your membership to greater use with a more robust e-commerce offering, you’ll be more likely to renew and consider an Executive membership upgrade.

Executive membership upgrades have been a tailwind for the US/Canada operations over the past decade. In 2009, Executive memberships accounted for 29% of all memberships; in fiscal 2021 it was 42%. Last year, 55% of US/Canada members had Executive memberships compared with just 17% of international members. Costco has added Executive membership offerings in Japan and Taiwan in recent years and we expect the Executive membership mix to improve overseas in the coming years.

Executive membership growth is important to our Costco thesis. First and most obviously, it increases membership fee revenue, which is pure profit. The second reason is that it encourages more spending at Costco. If a member spends at least $3,000 a year ($250 per month) at Costco, it makes sense for them to have an Executive membership given the 2% cash reward. Over the last twelve months, the average Executive membership spent $5,539 on merchandise versus $1,659 for Gold Card members. The former has made Costco a part of their regular shopping routine while the latter uses it more for one-off purchases. The more Costco can convince Gold Card members to routinely use their Costco membership, the more likely they’ll be to upgrade to Executive.

Costco’s international presence is still relatively nascent, and the company aims to add more warehouses outside of US/Canada in fiscal 2022. As was the case in US/Canada, each incremental warehouse in a country increases its membership base and bargaining power with suppliers, fostering the virtuous cycle in new markets. We are optimistic that Costco can further delight its international customers leading to more Executive memberships and more spending at its stores.

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